What are Moving Averages and How They are Applied to Forex Trading?

Defining Moving Averages

Moving average is not a single number. It is a set of numbers each of which is the average of the corresponding subset of a larger data sample. Moving average is frequently used with time series data to smooth out fluctuations during a short period of time and emphasize long-term trends and cycles.

In Forex trading and generally in finance, moving average is one of to most popular and preferred technical analysis indicators. Traders use it to forecast the next price movements when they invest in currencies, stocks and other financial instruments. Otherwise said, moving averages are used to highlight a downtrend or uptrend by reducing the “noise” that can confuse price interpretation, as they "flattens" out the price slop over a certain set of values. They are also used to measure momentum and define areas of possible support and resistance. Moving averages simply measure the average price or exchange rate of a currency pair over a specific time frame.

There are several types of moving averages and each of them is calculated in a unique way. In this article we will be talking about three major moving average types:

1. Simple moving average
2. Weighted moving average
3. Exponential moving average

The Simple moving average, which is also known as arithmetical moving average, is the simplest and most preferred by forex traders. It is calculated by adding up together all the numbers included in a data sample for a specified period of time and dividing the outcome by the total amount of numbers in the sample set (See Formula 1).

In forex trading, the simple moving average gives equal weight to each price value over the specified period. The users of sophisticated forex trading platforms define whether the high, low, or close is used and these price points are added together and averaged. This average price point is then added to the existing string and a line is formed. With the addition of each new price point the sample set drops off the oldest point.

A weighted moving average is any average that has multiplying parameters to give different weights to different data points. In technical analysis, the weighted moving average (WMA) has the specific meaning of weights which decrease arithmetically. In a t-day WMA the latest day has weight n, the second latest n − 1, etc, down to zero (See Formula 2).

The weighted moving average gives more emphasis to the latest data. Moreover, it allows traders to successfully smooth out a curve while having the average more responsive to current price changes.

The exponential moving average (EMA), also known as exponentially weighted moving average (EWMA) is an alternative way of "weighting" the more recent data. It is used by technicians to reduce the lag in simple moving averages. The EMA multiplies a percentage of the most recent price by the previous period's average price. Otherwise said, it applies weighting factors which decrease exponentially. The weighting applied to the most recent price depends on the specified period of the moving average. It is important for traders to remember that since the EMA puts more weight on recent prices, it reacts quicker to recent price changes than the simple moving average. Although the mathematics of an exponential moving average is complex, traders do not need to calculate it by themselves because most charting packages do it automatically and instantaneously once the time period is specified.

Applying Moving Averages to Forex Trading

Setting the time frames

In order to take advantage of moving averages as a technical indicator traders have to set the parameters (time frames) representing the moving average line over a specified period of time. The most commonly used time frames for moving averages are 10, 20, 50, and 200 periods on a daily chart. Usually, the longer is the time frame, the more accurate is the study. However, keep in mind that shorter term moving averages react in more quickly to market movements than long term and thus they provide earlier trading signals. 

Entering a position using moving averages

There are two important factors related to moving averages that may help traders enter profitable positions. The theory behind and the experience with the moving averages suggest that traders are supposed:

• To enter the market by buying (long) or selling (short) when a strong trend pulls back to a moving average line
• To enter when a moving average crossover is present

As it was mentioned above moving averages illustrates a smoothed out line representing the overall trend. The longer is the time frame, the soother the line will be. In order to assess the strength of a trend it is good to place 20, 50 and 200 periods SMA’s.  Typically, upward trend is present when the short-term average (20-period) is above the longer-term averages (50-period and 200-period) and the current price is above the 20-period SMA (See Graph 1, point A). Downward trend is present when the short-term averages cross below the longer-term average.

Crossovers appear when a shorter moving average crosses a longer one. For example, if the 20 day SMA crossed below the 50 day SMA, this may be seen as an indication that the pair will move in the direction of the shorter MA or otherwise said a downtrend should begin (See Chart 2, point B). Accordingly, if the short SMA crosses back above the longer SMA, for instance the point where the 20 day SMA crossed above the 50 day SMA, this may be viewed as a possible change in the trend.

It is important to remember that moving averages are calculated using historical prices and they reflect the market’s action only after at least some time has past. As the short moving average crosses over and above the longer moving average, this can be interpreted as a change in trend to the upside and the other way around. However, it is of crucial importance to know that moving average crossovers tend to generate more reliable results in trending market that tends to accomplish either new highs or new lows. In a range bound market environment, the moving averages may cross one another many times, and may tend to give us false trading signals. As a result, before undertaking any actions traders have to define the market as either trending or range bound.

Which moving average to choose?

When it comes to which moving average a trader should use, it always depends on his/her trading and investing stile and preferences. There are traders that prefer to use exponential moving averages in order to capture market changes quicker, because as we mentioned EMA is prone to quicker breaks. On the other hand, there are traders that look for identification of long-term trends and they usually choose simple moving averages.

It is good to remember that the more sensitive an indicator is, the more signals will be provided. These signals may prove timely, but with increased sensitivity comes an increase in false signals. The less sensitive an indicator is, the fewer signals that will be given, but less sensitivity leads to fewer and more reliable signals.

The dilemma above applies to moving averages as well. Shorter-term moving averages are more sensitive and generate more signals than longer-term moving averages. Furthermore, the EMA is likely to generate more trading signals because it is more sensitive to changes than SMA. However, there will also be an increase in the number of false signals. In contrast to shorter moving averages, longer ones are more reliable, but in most cases they come late. We suggest traders to experiment with different moving average lengths and types and examine the trade-off between sensitivity and signal reliability.